Limited liability companies offer economic and tax advantages
Dayman, Mark A
Vermont recently became the last state to enact a limited liability company (LLC) statute. The law is a boon for business by permitting the combination of the corporate benefits of limited liability and the economic flexibility of partnerships. Yet formation and operation of an LLC has tax ramifications which need to be addressed.
The Internal Revenue Code is generally silent with respect to LLC’s, since the IRS’ position is that the owners of the LLC, known as members, have associated together either as a corporation or a partnership. The IRS has established rules for distinguishing between partnerships and corporations based on six factual criteria which are normally corporate attributes. The first two criteria–an “association” and a joint profit motive–are identical for all business entities. In order to hold that an LLC is a partnership, the LLC must nor possess more than two of the remaining corporate attributes–limited liability; centralized management; continuity of life; and free transferability of interests.
Determining that the entity lacks the required characteristics and is not, therefore, a de facto corporation, is determined on a factual basis based upon the structure and management of the LLC. Assuming proper structuring, however, it is not difficult to meet the criteria, generally by providing for the’ termination of the LLC upon the departure of a member, and limiting the voting rights of any party which would obtain the economic rights in a member’s LLC interest without the consent of the other members. Assuming that the basic qualification issues can be met, there are a number of other tax considerations which must be addressed prior to either starting up a new business using the LLC option or transferring an existing business into LLC form.
Formation of an LLC for a new business venture is accomplished by its members transferring cash and property to the LLC in exchange for ownership interests. This transaction is generally tax free under established partnership regulations.
Conversion of an existing partnership or corporation to an LLC is more complex, and may be very troublesome for corporate conversions. For partnership conversions, the simplest process involves the contribution of partners’ interest in a partnership to a newly formed in exchange for the LLC interests, followed by the liquidation of the partnership into the LLC. Although exceptions apply, this type of transformation is generally tax free.
Corporate transfers are more complex. The common process involves the stockholders’ formation of an LLC, with LLC ownership interests issued in exchange for tie stock of the corporation. The corporation is subsequently liquidated into the LLC. Although the process is similar to the partnership transfer , the tax treatment is different. The liquidation will involve two taxable events–a corporate level tax based upon the appreciated value of the assets over the tax basis of the assets; and a liquidating dividend to the stockholder. For corporations with significant appreciated assets (ie, real estate, unrecognized receivables, goodwill, trademarks, customer lists), the corporate level tax could be prohibitive. The tax paid by the stockholders on the liquidating dividend will make the situation worse.
If the corporation is an S-corporation, some of the taxes may be avoided. Although the corporation still must recognize income to the extent of appreciation, the liquidating distribution may result in no additional taxes. If there is minimal appreciation, stockholders who have suspended losses due to basis limitations may lose the future benefits associated with the losses.
Careful planning can overcome some, if not all, of the negative tax ramifications. One certainty, as with all corporate reorganizations, is that a complete corporate valuation is necessary in order to quantify any tax liability and to form the basis for tax planning.
LLCs are viewed in many respects as limited partnerships under the IRC. The debts of the LLC normally are with recourse to the legal entity, but without recourse to the individual members unless personally guaranteed. Since such guarantees can alter the allocation of income and deductions among the LLC members, planning is required.
There are other partnership issues which must be addressed. As with limited partners, LLC members in a manager managed LLC may be considered “passive” unless substantial personal effort is spent in the business. Member managed LLC’s are generally not passive. If an LLC is member managed, earnings from non-passive activities will generally be subject to self employment taxes. But if the LLC is manager managed, and the member is not an active participant in the business, the earnings may not be subject to self employment taxes. Also, losses of LLCs are limited to a member’s basis in his ownership interest. In a significant advantage over the S-corporation, personal guarantees of the LLC members can be used to increase basis.
The use of the cash basis of accounting is frequently not allowed for limited partnerships; LLCs may be subject to these same limitations. The IRS has ruled in a private letter ruling that the cash basis of accounting can be used if the LLC does not expect losses, is a professional LLC, was not formed for tax avoidance purposes, the LLC interests were not “syndicated,” and the members manage the LLC. Whether the cash basis of accounting will be allowed if some, but not all, of these characteristics exist is uncertain.
LLCs offer businesses unique opportunities to limit personal liability while providing the flexibility of partnerships. There are, however, many tax issues which must be reviewed to determine whether the LLC form will be a good fit to a specific situation.
Mark A Dayman, CPA, is a partner in Dayman, Lurie & Goldsbury, in Burlington, a firm which provides both traditional accounting, audit and tax services, as well as advisory and consulting services.
Copyright Lake Iroquois Publishing, Inc. d/b/a Vermont Business Magazine Jul 01, 1996
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